Role of Commercial Banks in Economic Development

Written by gilberto fuentes

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Commercial banks are one source of financing for small businesses. (business plan 2 image by Kelly Young from Fotolia.com)

The role of commercial banks in economic development rests chiefly on their role as financial intermediaries. In this capacity, commercial banks help drive the flow of investment capital throughout the marketplace. The chief mechanism of this capital allocation in the economy is through the lending process which helps commercial banks gauge financial risk.

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Risk

One of the most significant roles of commercial banks in economic development is as arbiters of risk. This occurs primarily when banks make loans to businesses or individuals. For instance, when individuals apply to borrow money from a bank, the bank examines the borrower's finances, including income, credit score and debt level, among other factors. The outcome of this analysis helps the bank gauge the likelihood of borrower default. By weeding out risky borrowers, commercial banks lessen the risk of financial losses. As a result, loans that mature without any problems generate a larger pool of funds for the bank to lend, further supporting economic development.

Individuals

When commercial banks assess risk, they help ensure that loans go to creditworthy borrowers. In turn, borrowers typically use loan proceeds to finance major purchases, such as homes, education and other consumer spending. The effect of commercial bank lending generates economic activity from individuals who now have the necessary funds to finance their own endeavours.

Small Business

Commercial banks also finance business lending in a variety of ways. A business owner may solicit a loan to finance the start-up costs of a small business. Once funded, the small business may begin operations and embark on a growth plan. The aggregate effect of small business activity generates a significant portion of employment around the country. According to the U.S. Census Bureau, businesses employing between one and 19 people accounted for 4.4 million jobs in 2004. In contrast, businesses with more than 20 employees only accounted for 1.2 million in the same year.

Government Spending

Commercial banks also support the role of the federal government as an agent of economic development. Generally, commercial banks help fund government spending by purchasing bonds issued by the Department of the Treasury. Both long and short term Treasury bonds help finance government operations, programs and support deficit spending.

Wealth

Commercial banks also offer types of accounts to hold or generate individual wealth. In turn, the deposits commercial banks attract with account services are used for lending and investment. For example, commercial banks commonly attract deposits by offering a traditional menu of savings and current accounts for businesses and individuals. Similarly, banks offer other types of timed deposit accounts, such as money market accounts and certificates of deposit. Some investors use these interest bearing, low risk accounts to hold money for investment purposes, waiting for attractive investment opportunities to materialise